Inflation is still worrisome enough that more rate increases, not cuts, could follow the Fed's 'pause.'

By Chris Isidore, CNNMoney.com senior writer

October 20 2006: 6:22 AM EDT

NEW YORK (CNNMoney.com) -- Inflation barely seems to be on the mind of investors any more.

Rates in the inflation-sensitive Treasury bond market indicate investors believe prices and wages are all but under control. The Dow industrials have been hitting record highs - and closed above 12,000 for the first time on Thursday - partly on the belief that inflation is tame enough to allow the Federal Reserve to start cutting interest rates soon after more than two years of rate hikes.

Fed Chairman Ben Bernanke was a longtime advocate of the Fed making rate decisions based on firm inflation targets.

Frederic Mishkin, the newest Fed governor, wrote a book with Bernanke advocating inflation targeting.

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Those expectations didn't change this week, even as government readings on inflation at the retail and wholesale level both showed an important inflation gauge excluding volatile food and energy costs to be well above the 1 to 2 percent range widely assumed to be the Fed's comfort zone.

The markets weren't overly rattled by the reports. Stocks rallied Wednesday and bond yields fell further after the Consumer Price Index report, a sign investors believe rates are heading lower, not higher.

But some Fed watchers think the central bank's policy-makers are more concerned about inflationary pressures than are most investors on Wall Street.

And they think the Fed policy-makers will start sending signals to the markets soon that when it's done with its current "pause" the Fed's next move could be to start raising rates, not cutting them, as many on Wall Street have been hoping.

"One gets the sense that the Fed is trying to warn off the markets from a false sense of confidence that rate cuts are around the corner," said Tom Schlesinger, executive director at Financial Markets Center, a research firm that closely follows the Fed.

That doesn't mean that even those who are looking for more rate hikes from the Fed are expecting an increase at its meeting next week. Even those inflation "hawks" agree with most economists, who forecast the Fed will hold its key short-term rate target steady at 5.25 percent next week.

The Fed raised rates for two years in a bid to slow economic growth and ward off inflation before the central bank paused at its meetings in August and September.

Many on Wall Street have been betting the Fed's next move will be cut rates, perhaps early in 2007, to keep the economy from stalling or even dipping into recession.

But some of those now expecting rate hikes from the Fed say it's politics, more than economics, keeping the central bank on hold now with the hotly contested midterm elections less than two weeks away.

"Typically they try to avoid doing it right before the election," said Adam Posen, senior fellow at the Institute for International Economics.

Posen said he believes there is already close to a consensus on the Federal Reserve in favor of a policy known as "inflation targeting," in which the central bank would spell out what levels of inflation would cause it to raise or cut rates.

Fed Chairman Ben Bernanke was well known as an advocate of targeting before he took the helm as chairman from Alan Greenspan earlier this year. So is Frederic Mishkin, the newest Fed governor, who joined the central bank on Sept. 5. In fact Posen wrote one of the key economic books in favor of targeting with Bernanke and Mishkin.

But Posen said that the advocates of inflation targeting at the Fed won't get ahead of Congress, which is likely to be reluctant to see targeting put into place, no matter which party wins controls of Congress next month.

"Bernanke is a politically sound person," said Posen. "He was never going to rush to push targeting. You need consensus on it."

Posen added that even if an inflation-targeting policy were in place right now, the Fed might well have left rates unchanged the past two meetings, and again next week, because of mixed signals on inflation and a slowing economy, which usually lessens upward pressure on wages and prices.

"I think the Fed was correct some months ago when it made the assessment that there was bigger downside risk [to the economy] from housing than upside risk [of inflation] from energy prices," said Posen. But now, "it's probably time to start think about raising rates again," he said, noting that "doesn't mean [Fed policy-makers] were wrong when they paused."

But some economists say that with an inflation-targeting policy, the Fed would have kept raising rates at its last two meetings rather than pausing.

"The measure they tell us is the key inflation reading is at an 11-year high," said Rich Yamarone, director of economic research at Argus Research, referring to a price deflator in the Commerce Department's personal income and spending report. "I would assume under a rules-based policy, they would be raising rates. You're starting to see how the facts and the dynamic economy make inflation targeting difficult if not impossible."

Even some economists who believe that inflationary pressures are currently on the retreat say they expect the Fed will next have to raise rates, not cut them, as they see signs that the economy is not cooling as much as some had feared earlier this year.

"The markets think the worst of inflation pressures are over, and I think they're right," said economist Bernard Baumohl of the The Economic Outlook Group, a Princeton, N.J., research firm. "But there's reason to believe by mid-2007 that the economy will take off again."

Others, like Yamarone, argue the central bank is already behind the curve, even if these inflation hawks aren't expecting a rate hike before the end of this year.

"The Fed itself must be getting spooked. The arguments that the economy is cooling were overblown," he said. "But they sold the idea of the pause and the markets believed them."

Those expecting the Fed to start raising rates say the governors will have to prepare the markets for such a move before they can start raising. So they expect the Fed's statement after next week's meeting to start to lay the groundwork for such a move, perhaps by saying the risks of an economic slowdown have lessened or by calling more attention to inflation risks.

Then they expect comments from the Fed policy-makers in various speeches to start to take on a much more hawkish tone the rest of the year.

"I expect the Fed to be be conducting an open-mouth monetary policy," said Yamarone.